The great wall of money

China's economy may be less vulnerable to a bursting of the stockmarket bubble than it appears

THE Chinese consider four to be a very unlucky number (because in Mandarin it sounds like the word death). The number 4444 is thus presumably as bad as it gets. So suppose the Shanghai A-share index closes during the next week at 4,444 (it stood at 4,375 on May 23rd), which is quite possible given its 258% gain since the beginning of 2006; might that frighten investors enough to cause the share-price bubble to burst?

It would surely impress them more than the package of measures announced by the People's Bank of China (PBOC) on May 18th: a rise in both interest rates and banks' reserve requirements, and a widening of the yuan's daily trading band against the dollar, from 0.3% to 0.5%. The latter was largely a symbolic gesture coming just days before the second Strategic Economic Dialogue between China and America that started in Washington on May 22nd. It does not imply a faster pace of appreciation, because the yuan had never hit its previous trading limits; within the old band it could have risen by much more than it did. On the other hand, the PBOC's decision to raise deposit rates by more than lending rates (for example, the five-year deposit rate increased by 54 basis points, the five-year lending rate by only nine points) clearly signalled that its aim was to cool the stockmarket, by trying to discourage the shift from bank savings into shares, rather than to squeeze the real economy. The market, however, once again shrugged off the tightening and rose to a new high. That is hardly surprising since interest rates are still ridiculously low: the benchmark one-year deposit rate was raised to 3.06%, but that still left the after-tax real rate negative.

What is peculiar about China's stockmarket is that government officials, the PBOC, the media, investment bankers, not to mention Li Ka-shing, Hong Kong's richest tycoon, and Alan Greenspan, the former chairman of the Federal Reserve, have all warned that it looks like a bubble. This is in striking contrast to most bubbles, notably in dotcom shares and America's housing market, where most officials and financiers remained in denial until they popped. Chinese shares certainly look expensive, with an average price-earnings ratio of almost 50 (based on historic profits). But p/e ratios are hard to interpret when profits are growing so strongly. Over the past decade China's p/e ratio has averaged 37, much higher than elsewhere. According to Goldman Sachs, firms listed on the A-share market enjoyed an average 82% increase in profits in the year to the first quarter. It is also worth noting that China's recent surge followed many years of decline. As a result, China has been the worst performer among the BRIC economies—Brazil, Russia, India and China—since 2003 when the global bull market began (see left-hand chart).

Assume for the moment that this rally is in fact a bubble and that it eventually bursts; what would be the impact on China's economy? Newspapers abound with stories suggesting that everybody from students and pensioners to cleaners and taxi drivers is playing the stockmarket. If true, a collapse in share prices would bring the whole economy down with it. But China's stockmarket is still relatively small, so price movements—up or down—have less impact on spending than elsewhere. Despite the surge in share ownership this year, only 7% of the population own shares, reckons Hong Liang, an economist at Goldman Sachs, compared with around half of all Americans.

A panda or a grizzly bear

The total value of tradable shares—that is, excluding those held by the government—is only 25% of GDP (the market capitalisation is nearly 80%). This compares with 150% in America and over 100% in India (see right-hand chart). And according to an article in the latest China Economic Quarterly, a large chunk of tradable shares is actually held by state firms and government agencies, so the true exposure of individuals is even smaller.

Swings in share prices affect an economy in two main ways. The first is through the “wealth effect”: higher share prices encourage consumers to spend more; they then pull in their belts when share prices plunge. When Chinese share prices collapsed by 55% from 2001 to 2005, consumer spending and GDP growth proved robust. Today there are more shareholders, but their holdings are still small. Equities account for less than 15% of Chinese households' total financial assets, compared with half of those of American households' (including their pension funds). In America the share-price boom in the late 1990s made people think that they no longer needed to save, but in China there has been little sign over the past year that people are saving much less; the boom in retail sales has largely matched faster growth in income. If consumers have not spent their capital gains, then a slump in share prices should not have much impact either.

The second channel through which share prices usually affect an economy is the cost of capital; higher share prices make it cheaper for firms to raise equity finance and so they invest more. But only a small proportion of Chinese companies are listed on the stock exchange and those that are rely more on internal finance. About 60% of private-sector investment is funded from companies' own profits and another 20% from banks; issuing shares accounts for only 10%. A stockmarket crash will therefore not make much of a dent on investment.

The direct economic impact of a fall in Chinese share prices would therefore be modest. Some indirect effects could be larger. For instance, the psychological impact of a sharp sell-off could severely puncture consumer confidence. Chinese authorities are also nervous about social and political instability among angry students who have bet their tuition money on shares, or pensioners who have blown their life savings. Another indirect threat is the impact of a collapse in Chinese shares on other markets. A 9% drop in Chinese share prices in late February triggered a brief global sell-off. Given the frothy state of many global financial markets, a full-blown crash in China might thus do more harm abroad than at home. Financial instability could be China's next unwelcome export.